🪅Global Monetary Economics Unit 19 – Monetary Policy: Global Case Studies

Key Concepts and Definitions

• Monetary policy involves central banks' actions to influence money supply and interest rates to achieve macroeconomic objectives (price stability, economic growth, full employment)
• Inflation targeting establishes an explicit numerical target for inflation rate over a specified time horizon
  • Aims to anchor inflation expectations and enhance central bank credibility
• Quantitative easing (QE) is an unconventional monetary policy tool where central banks purchase long-term securities to increase money supply and stimulate lending and investment
• Forward guidance communicates central bank's intentions about future monetary policy stance to influence market expectations and long-term interest rates
• Nominal interest rate is the stated interest rate without adjusting for inflation, while real interest rate accounts for inflation by subtracting expected inflation from nominal rate
• Liquidity trap occurs when nominal interest rates are near zero, limiting central banks' ability to stimulate economy through conventional monetary policy
• Monetary policy transmission mechanism describes channels (interest rate, credit, exchange rate, asset price, expectations) through which monetary policy actions affect real economy

Historical Context of Monetary Policy

• Gold standard era (late 19th to early 20th century) linked currency values to gold, constraining monetary policy flexibility
  • Abandoned during Great Depression to allow expansionary policies
• Bretton Woods system (1944-1971) established fixed exchange rates pegged to US dollar, which was convertible to gold
  • Collapsed due to US balance of payments deficits and inflationary pressures
• Post-Bretton Woods era saw transition to floating exchange rates and increased monetary policy independence
• Great Inflation of 1970s led to adoption of monetary targeting and increased focus on price stability
• Global financial crisis (2007-2009) prompted unconventional monetary policies (QE, negative interest rates) to combat deflationary pressures and stimulate recovery
• COVID-19 pandemic triggered unprecedented monetary policy responses, including large-scale asset purchases and near-zero interest rates, to support economies

Major Monetary Policy Tools

• Open market operations involve central banks buying or selling short-term government securities to influence money supply and short-term interest rates
• Reserve requirements set the minimum amount of customer deposits banks must hold in reserve, affecting banks' lending capacity
• Discount rate is the interest rate central banks charge on loans to commercial banks, influencing borrowing costs and credit availability
• Interest rate targeting involves setting a target for short-term interest rate (federal funds rate in US) and adjusting money supply to achieve the target
• Large-scale asset purchases (QE) aim to lower long-term interest rates, boost asset prices, and stimulate borrowing and spending
• Forward guidance shapes market expectations about future monetary policy actions, influencing long-term interest rates and economic activity
• Yield curve control targets specific longer-term interest rates by committing to buy or sell securities to maintain the target rate
• Negative interest rates charge banks for holding excess reserves, encouraging lending and investment to stimulate economy

Case Study: US Federal Reserve

• Dual mandate pursues maximum employment and price stability, with 2% inflation target
• Federal Open Market Committee (FOMC) sets monetary policy through open market operations, discount rate, and reserve requirements
  • Consists of seven Board of Governors members and five Reserve Bank presidents
• Responded to 2007-2009 financial crisis with near-zero federal funds rate, QE, and forward guidance to support recovery
• Implemented QE through purchases of Treasury securities and mortgage-backed securities to lower long-term rates and stimulate housing market
• Gradually normalized policy post-crisis, raising rates and reducing balance sheet, until COVID-19 pandemic
• Pandemic response included cutting federal funds rate to 0-0.25%, QE, and various lending facilities to support businesses and municipalities
• Faces challenges in unwinding accommodative policies and managing inflation expectations as economy recovers

Case Study: European Central Bank

• Primary objective is price stability, defined as inflation below but close to 2% over medium term
• Governing Council, comprising Executive Board and euro area national central bank governors, sets monetary policy
• Main refinancing operations provide short-term liquidity to banks through weekly auctions
• Faced sovereign debt crisis (2010-2012) in several euro area countries (Greece, Ireland, Portugal, Spain, Italy)
  • Introduced Outright Monetary Transactions (OMT) program to purchase sovereign bonds of distressed countries, calming markets
• Implemented negative deposit facility rate in 2014 to combat deflationary pressures and stimulate lending
• Launched large-scale QE (APP) in 2015, purchasing government bonds, corporate bonds, and asset-backed securities
• Pandemic Emergency Purchase Programme (PEPP) in 2020 provided additional QE to support euro area economy during COVID-19 crisis
• Challenges include divergent economic conditions among member states and limited fiscal policy coordination

Case Study: Bank of Japan

• Pursues price stability and sustainable economic growth, with 2% inflation target
• Pioneered unconventional monetary policies to combat prolonged deflation and low growth since 1990s
• Zero interest rate policy (ZIRP) in 1999 lowered overnight call rate to nearly zero
• Quantitative easing (QE) in 2001 targeted current account balances held by banks at BOJ
• Comprehensive Monetary Easing (CME) in 2010 included "virtually zero" interest rate policy and asset purchases
• Quantitative and Qualitative Monetary Easing (QQE) in 2013 aimed to achieve 2% inflation target through large-scale asset purchases and doubling monetary base
  • Expanded in 2014 to include purchases of exchange-traded funds (ETFs) and real estate investment trusts (REITs)
• Yield curve control (YCC) introduced in 2016 to target short-term and long-term interest rates (0% for 10-year government bond yield)
• Challenges include overcoming deflationary mindset, stimulating private sector growth, and managing government debt sustainability

Emerging Market Monetary Policies

• Diverse group with varying economic structures, financial market development, and institutional frameworks
• Many adopted inflation targeting (Brazil, Chile, Mexico, South Africa, Turkey) to anchor expectations and build credibility
  • Requires flexible exchange rates, central bank independence, and transparent communication
• Some manage exchange rates (China, India) to support export competitiveness and financial stability
  • Accumulate foreign exchange reserves to intervene in currency markets
• Vulnerable to external shocks (commodity price fluctuations, global financial conditions, capital flow volatility)
  • May use capital controls or macroprudential measures to manage risks
• Limited monetary policy space due to inflationary pressures, fiscal dominance, and balance sheet vulnerabilities (currency mismatches, foreign currency debt)
• COVID-19 pandemic prompted rate cuts, asset purchases, and liquidity support, but magnitude constrained by external financing pressures and inflation concerns
• Challenges include strengthening monetary policy frameworks, deepening financial markets, and coordinating with fiscal and structural policies

Global Implications and Interconnections

• Monetary policy spillovers occur when actions in major advanced economies (US, euro area, Japan) affect global financial conditions and capital flows
  • US dollar's dominance amplifies spillovers through trade invoicing, financial market transactions, and debt denomination
• Divergent monetary policies can lead to exchange rate volatility and trade tensions
  • US rate hikes in 2015-2018 appreciated dollar, pressuring emerging markets with external vulnerabilities
• Synchronized global easing during COVID-19 pandemic mitigated spillovers but raised concerns about asset price bubbles and excessive risk-taking
• Policy coordination through G20, Financial Stability Board (FSB), and Bank for International Settlements (BIS) aims to manage spillovers and promote financial stability
  • Initiatives include global financial safety net, macroprudential policies, and cross-border regulatory cooperation
• Global value chains and integrated financial markets transmit shocks across borders, requiring monitoring and risk management
• Climate change poses long-term challenges for monetary policy through physical risks (supply shocks) and transition risks (stranded assets, policy changes)
  • Central banks increasingly incorporate climate considerations into monetary policy frameworks and financial stability assessments
• Digitalization and rise of crypto-assets present opportunities (improved payments, financial inclusion) and risks (money laundering, consumer protection) for monetary policy and financial stability
  • Central bank digital currencies (CBDCs) explored as potential response to declining cash use and private digital currencies